Eco 600E Advanced Microeconomics I Term: Spring (1st), 2008 Lecturer: Yosuke Yasuda Problem Set 1: Solutions Due

in class on April 22 1. Question 1 (20 points) Suppose a preference relation % on X is rational. Then, show the followings. (a) Re exive: For any x 2 X, x x. (10 points) Since % is complete, x % x must hold. It is immediate that x % x (and x - x) implies x x. (b) Transitive: For any x; y; z 2 X, if x By denition of strict preference , x y y and y z, then x z. (10 points)

y , x % y and not y % x z , y % z and not z % y

Since % is transitive, x % y and y % z implies x % z. Now, suppose z % x. By x % y and transitivity, we must have z % y, which contradicts to the assumption (y z). Therefore, z % x cannot happen. Note that x % z and not z % x implies x z, concluding the proof. 2. Question 2 (50 points) There are two goods, whose quantities are denoted by X and Y , each being a real number. An individual consumption set consists of all (X; Y ) such that X 0 and s Y > 2. His utility function is: U (X; Y ) = ln(X + 3) + ln(Y 2).

The price of X is p and that of Y is q; total income is I. The aim of the question is to nd the consumer demand functions and examine their properties. You need not s worry about second-order conditions. Proceed as follows: (a) First solve the problem by Lagrange method, ignoring the constraints X s 0, Y > 2. Show that the solutions for X and Y that you obtain are valid demand functions if and only if I 3p + 2q. (20 points) Need to solve: maxX;Y U (X; Y ); s:t:pX + qY I. 1

Let L := ln(X + 3) + ln(Y 2) + (I pX qY ) and solve the unconstrained maximization problem with respect to X; Y and . FOCs are as follows: @L 1 = @X X +3 @L 1 = @Y Y 2 @L = I pX @ By (1) and (2), we can derive q(Y we obtain I pX p=0 q=0 qY = 0 (1) (2) (3)

2) = p(X + 3). Substituting for Y into (3),

(pX + 3p + 2q) = 0 2pX = I I X=

3p 2q 3p 2q . 2p

(4)

Solving for Y by plugging equation (4) into (3) gives: Y = I + 3p + 2q 2p

Thus, the demand as a function of the prices, p and q, and income, I, is: (X; Y ) = ( I 3p 2q I + 3p + 2q ; ) 2p 2p

which only makes sense if I 3p + 2q, so that the demand for each good is always non-negative. Note that the condition that Y > 2 is also satised whenever I 3p + 2q. (b) Next suppose I 3p + 2q. Solve the utility maximization problem subject to the budget constraint and an additional constraint X 0, using Kuhn-Tucker theory. Show that the solutions for X and Y you get here are valid demand functions if and only if 2q < I 3p + 2q. What happens if I 2q? (10 points) If I < 3p + 2q, we see from (a) that unconstrained demand for X would be negative. If we impose that X 0, we know from Kuhn-Tucker theory that the consumer will optimize demand by setting X = 0 exactly. Thus, he will reach his best utility outcome by purchasing good Y only. With income I, he can purchase

I=q units of good Y . So his total demand is: I (X; Y ) = (0; ) q Note that this demand function holds only for 2q < I 3p + 2q. If I > 3p + 2q, we have the demand function as in (a). If I 2q, then the consumer will not have enough money to buy even 2 units of Y , thus not allowing him to achieve any utility above negative innity. In this case, we say that utility is not clearly dened (since ln(Y 2) does not exist), so demand is not dened either. (c) Show that the demands are homogeneous of degree 0 in (p; q; I) jointly. (5 points) Skip. (d) Find the algebraic expressions for the income elasticities of demand for X; Y . Which, if either, of the goods is a luxury? (5 points) Note that an income elasticity for each good is calculated by: ( When I @X I @Y I ; ) @I X @I Y

3p + 2q; the income elasticity of demand is: ( I I 3p I ) 2q I + 3p + 2q ; 3p + 2q, the

Since the former exceeds 1, good X is a luxury good. If 2q < I income elasticity of demand is: (0; 1) So, neither one is a luxury good in this case.

(e) Find the marginal propensities to spend on the two goods. Which, if either, of the goods is inferior? (5 points) The marginal propensity to spend is just the rst derivative of demand relative to income: 1 1 ( 2p ; 2q ) @X @Y if I 3p + 2q ( ; )= 1 (0; q ) if 2q < I 3p + 2q @I @I Note here that the rst derivative w.r.t. income is everywhere non-negative. Thus, neither good is an inferior good. (f) Find the algebraic expressions for the own price derivatives @X=@p, @Y =@q. Which, if either, of the goods is a Gien good? (5 points) 3

The price derivatives are as follows: ( ( I2p2q ; @X @Y 2 ( ; )= (0: @p @q

I+3p ) 2q 2 I ) q2

if I 3p + 2q if 2q < I 3p + 2q

We see that the price derivatives are negative (and demand is equal to 0 at I = 3p + 2q), meaning that demand decreases in the price of each good. Thus, neither good is a Gien good. 3. Question 3 (30 points) (In this question, you can use Lagrange method taking for granted that the seconds order conditions are satised and boundary solutions do not arise.) There are two goods X and Y , with prices p and q. A consumer utility function is s U (X; Y ) = X 1=3 Y 2=3 . (a) Find algebraic expressions for the quantities that solve the usual problem: max U (X; Y ) s.t. pX + qY I

These are functions of (p; q; I), and are called Marshallian demand functions. Denote them by X m and Y m . Find the algebraic expression for the resulting utility u also as a function of (p; q; I). (15 points) Using Lagrange method, you can obtain the following Marshallian demand funcs tions: I 2I (X m ; Y m ) = ( ; ) 3p 3q Plugging these demands into the utility function, we get: u = U (X m ; Y m ) = (X m )1=3 (Y m )2=3 =( I 1=3 2I 2=3 22=3 ) ( ) = 1=3 2=3 I 3p 3q 3p q

(b) Now consider the mirror-image problem: how much income is needed to achieve at least a specied target utility level u if the consumer makes the most economical choices: min pX + qY s.t. U (X; Y ) u These are functions of (p; q; u), and are called Hicksian demand functions. Denote them by X h and Y h . Find algebraic expressions for X h and Y h . (10 points) 4

Again, Lagrange method leads you to obtain the following Hicksian demand funcs tions: 2p q (X h ; Y h ) = (u( )2=3 ; u( )1=3 ) 2p q (c) Evaluate @X h =@q and Y m @X m =@I. Show that the two are equal when u and I are related by the expression you found in (a) above. (5 points) By calculation, 21=3 u 3p2=3 q 1=3 2 I Y m @X m =@I = 9pq @X h =@q = Substituting u =
22=3 I 3p1=3 q 2=3

in the rst line, we obtain 2 I = Y m @X m =@I. 9pq

@X h =@q =